SEBI Ban on NFOs for 3 Months – What are the reasons behind it?

Asset management companies in India have been informed by SEBI to halt the launch of any new fund offers in the next three months. This comes in line with the market regulator’s earlier warning to the mutual fund industry regarding compliance with various norms on funds being pooled by distributors and other intermediaries. Until now, brokers and other mutual fund distributors that helped investors make mutual fund investments were able to pool funds into their accounts before transferring them to the fund houses or clearing corporation.

Here is everything that investors need to know about the NFO ban and whether it will prove beneficial.

Background of NFO ban announcement

The Securities and Exchange Board of India (SEBI) had directed the mutual fund industry back in October 2021 to disallow funds from being pooled on behalf of investors. The directive stated that any funds pooled for mutual fund investment should directly go from an investor’s account to the mutual fund. Post this directive, the industry sought additional time to implement moves that comply with the new expectations. Therefore, the deadline for the implementation of the rule was extended.

What does SEBI expect from AMCs?

SEBI’s initial directive around pooling of funds came In October 2021, and it was followed by additional clarifications in March 2022. As part of this directive, the regulator asked fund houses to various intermediaries, like stockbrokers, investment advisors, mutual fund distributors, etc stop the usage of pooled accounts to collect funds and mutual fund units on behalf of investors. This ruling is believed to be a result of the aftermath of Karvy Stock Broking’s fallout.

What is pooling of funds?

Fund pooling acted as a wallet held by intermediaries. Through this, funds were being collected from investors and mutual fund units for investment or redemption were passed on to investors. To put it simply, an investor’s money would first go to the intermediary’s pooled account once he/she made a fund purchase request. The broker would then credit the investor’s money to the fund house. Thus, the investor’s money was effectively being passed through an intermediary.

Risks involved in fund pooling

To protect investor interest and eliminate the risk of fund diversion by intermediaries, SEBI mandated mutual fund houses to prohibit such pool accounts or fund pooling accounts. According to the regulator, this will ensure a smooth and direct flow of funds and mutual fund units between fund houses and investors. 

Two-factor authentication

For enhanced risk mitigation, the regulator instructed fund houses to have a two-factor verification for authenticating transactions related to online fund unit redemption and verifying source details of the bank accounts.

Here is an example to understand this mechanism. At the time of initiating an online transaction, an investor usually has to log into his/her bank account by entering a password. This is the first step of verification. As a next step for proceeding with the transaction, an investor must provide an OTP authentication for validating it.

The new norms were to come into effect from Oct’21. However, AMFI or the Association of Mutual Funds in India requested the capital market regulator to extend this deadline to July 1, 2022. The regulator provided Mar’22 as the final deadline and also announced the suspension of any further NFOs until all the AMCs agree to comply with the norms.

How does the NFO ban impact investors?

With the bank on NFOs as a result of failure to comply with the new norms, SEBI has given a clear indication to all AMCs about the criticality of protecting investors’ interests. 

With the suspension of NFOs, investors are not expected to be highly impacted as there are several mutual funds already available in the market. In contrast, this is a good move for investors, as they can expect enhanced protection against any monetary losses in the future.

In the interim, it is best for investors to check with the mutual fund intermediaries regarding any impact on their ability to transact in mutual funds through intermediaries.

How are AMCs viewing the NFO ban?

As per Association of Mutual Funds in India (AMFI), all mutual fund houses are in agreement with the SEBI decision on pausing NFOs since it will provide sufficient time for the AMCs to upgrade and align technological processes to SEBI norms.

The mutual fund industry is positive about protecting investor interests and avoiding any chances of fraud, apart from containing operational risks.

Conclusion

Every since the Karvy Stock Broking episode of illegal fund transfer and misuse of funds came to light, SEBI has been extra vigilant about identifying any possible loopholes in the mutual fund business operations. The latest move around NFOs is also aimed at maximising investor interest and curbing all possibilities of fraud in the investment process.

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